In The Airline Business We Just Do Not Talk About Balance Sheets Enough

In the Gulf States, we have Qatar CEO Akbar Al Baker saying to Gulf Business Nothing Can Stop Us Now.  In the article Al Baker talks about the high cost and inefficient airlines in the west.  In the U.K., a headline in The Independent reads:  More Carriers Could Fold Warns IAG’s Willie Walsh.  Bruce Smith, writing for the Indianapolis Star publishes a story on hometown Republic Holdings titled:  Republic Emphasizes Cost Cuts As It Fights To Compete.  Like a lot of airlines these days, Republic’s branded carriers – otherwise known as Frontier and Midwest  – are not only fighting to compete, they’re fighting to simply stay alive.

It’s easy to forget Republic now flies its own airline flag. Prior to purchasing Frontier and Midwest out of bankruptcy, Republic Holdings’ predominately did fee-for-departure flying for U.S. network carriers.  In October 2008, I asked:  Just Who Will Inherit the U.S. Domestic Market? Don’t Forget Today’s “Regional Carriers”.  Nearly two years ago, after Republic staved off Southwest from sponsoring Frontier’s exit from bankruptcy, I asked,  Is Republic Changing the Face of the US Domestic Market?   

In each of the Swelblog.com articles referenced above, I talked about how smart Bryan Bedford, CEO of Republic Holdings (RJET) is.   Bedford made the move to acquire Frontier and Midwest in an environment where it was increasingly clear the legacy carriers did not – and cannot over the long-term – operate under a cost structure that will not support the number of airlines trying to survive in the hypercompetitive U.S. domestic airline business.  Since then, consolidation among U.S. carriers has taken off – for network, low cost and regional airlines alike.

Smart or not, the price of jet fuel puts pressure on Bedford’s balance sheet more so than other carriers given Republic’s incipient fragility.  I have written time and again the most important financial statement for any airline today is its balance sheet.  As Republic Holdings trades near a 52 week low, many analysts are jumping off the RJET bandwagon.

Mike Linenberg, equity analyst at Deutsche Bank, wrote following Republic’s first quarter results, “Republic ended the March quarter with $467 million in total cash, $37 million higher than at the end of the December quarter. While the company’s restricted cash balance increased $87 million to $226 million, driven by the seasonality of its Frontier business, unrestricted cash declined $50 million to $241 million, impacted by the company’s relatively high credit card holdback provision of 95%. Regarding additional sources of cash, Republic indicated that it had some collateral-backed debt that could be refinanced to produce an additional $70- $80 million of net cash to the company.”

In the airline business, cash is king and fuel is the wildcard. With its fee-for-departure contracts, Republic left the fuel risk to its mainline partners.   (Of course the price of fuel affects the decision of the mainline carrier as to whether to buy regional capacity).  Now Bedford has to buy fuel for his Frontier and Midwest subsidiaries… that helps to explain why RJET’s unrestricted cash declined by some $50 million.

Why I was bullish on the Republic – Frontier combination in the early days was because the Indianapolis based holding company had bought a brand, one that came with a vibrant flying community – Denver.  With a community comes inherent demand.  With demand comes revenue.  But Last month, Ann Schrader of the Denver Post reported Southwest had jumped over Frontier in terms of market share at DIA.    

Republic announced the acquisition of Frontier on June 22, 2009.  On that date, the price of a barrel of West Texas Intermediate (WTI) crude oil was $64.58 and the price of a gallon of jet fuel was $1.78.  In 2011, WTI has traded in excess of $100 per barrel and one gallon of jet fuel tops $3.  It is one thing to be in the regional business when the cost of fuel doesn’t directly affect you. It’s another when you actually have to pay for the gas.

Southwest

On the flip side, I think that Southwest’s purchase of AirTran is brilliant.  In many catchment areas around the contiguous 48 states most populated and wealthy areas, the combined carrier has at least two beachheads.  While I still don’t believe Southwest, jetBlue, Frontier and Spirit will inherit the domestic U.S. marketplace; I am increasingly convinced the not-so-meek Southwest will inherit more earth than any of the others.  The U.S. domestic market has always been about the survival of the fittest. 

Might we be headed for another round where Southwest captures five points of domestic market share?  Possibly. What’s different this time versus the 2001 – 2006 period when Southwest and the other LCCs captured nearly 20 points of domestic market share is the airlines losing ground won’t be the network carriers.  More will come from weak competitors – like Frontier, Midwest and Spirit. .  There should be little surprise that Spirit sold a fraction of its intended shares at 25 percent less than desired price in its Initial Public Offering (IPO). 

Frontier is quickly losing pricing power in the very place it called home.  Presumably the value in the Frontier franchise was its cult following in the Denver local market. Without a meaningful, and growing, share of the local market, pricing power is compromised.  No pricing power in a high jet fuel cost environment does little to bolster a fragile balance sheet.  Southwest has the time and the financial wherewithal to whittle Frontier's following and, thus, its franchise value.

Southwest isn’t Frontier’s (and Bedford’s) only headache. United has a presence in Denver as well, one that’s not necessarily focused on local traffic. That makes Denver somewhat different than other cities where three carriers have tried to hub.  My guess is something is going to give in Denver because, at some point, the law of diminishing returns is sure to play out for any one of the three competitors.  And I’ll bet on Southwest’s balance sheet winning the war.

Southwest is an opportunistic competitor.  I expect Southwest to fill any voids left by either Frontier or United in Denver.  Where United or Frontier might be vulnerable, Southwest will likely exploit that weakness by adding capacity.  It can be patient because Southwest has a balance sheet that is far stronger than either of its two Denver competitors.  Frontier is, by far, the weakest. The high cost of fuel is its immediate enemy and Frontier has fewer options than either Southwest or United.

Labor - It Really Is About The Balance Sheet

The one thing that the pre-Frontier/Midwest Republic did not have to worry about was earnings as long as it delivered the product promised to the mainline carriers.  Today, the branded operation is suffering losses and is forecast to lose money going forward while most major players are going to make money.  As Linenberg’s analysis suggests, Frontier needs to generate cash internally because it has limited borrowing capability.

The strong get stronger.  The weak get weaker.  Survival of the fittest at its most emblematic. As Bryan Bedford told his shareholders – and the world - he needed to find $100 million in cost savings, his pilots protested outside.  No earnings and a weak balance sheet usually do not equal wage increases. It’s not about whether pilots deserve increases – that’s not what I’m talking about.  Balance sheet repair is not sexy.  Balance sheet repair does not add to earnings.  Balance sheet repair does not produce wage increases and work rule changes that resemble 2001.

What balance sheet repair does is keep airlines flying. If struggling carriers don’t find ways to fix their sheets, they won’t be around. I don’t mean they’ll file Chapter 11 and hope to reorganize or sell themselves off at the last minute. I mean they will cease to exist. Their one-time employees will be out of work, their assets will be auctioned off. No one is going to pump capital into an airline whose balance sheet is out of whack, whether that’s because of fuel, diminished market share or labor costs.  

It really is why pattern bargaining should be a thing of the past.  Every airline is different.  Every airline competes in different geographies, with different goals and has labor needs that other carriers don’t. 

The more I think about it, US Airways pilots – and whichever union/group is currently representing them - are really doing the company a favor by not coming to grips with reality.  US Airways is more exposed in the U.S. domestic market than any other network carrier.  The U.S. domestic market is a low-fare environment and requires lower labor costs than, say, a United or a Delta that have more capacity in international markets.  The same holds true for flight attendants and below-the-wing personnel. More to come on this one.

I see employees picketing and I scratch my head.  This industry lost nearly one in every four jobs during the past decade, yet still has more than 350,000 employees with wage and benefit packages in excess of $85,000.  This is an industry of good paying jobs despite the economic environment it operates in. Yet many labor groups refuse to recognize the need for balance sheet repair… and that labor costs have to be part of the fix. You can’t just tweak revenue or fuel costs or charge more for a ticket. Shoring the balance sheet requires a holistic approach.

Without that type of approach, as Willie Walsh recently said, more airlines will fold.  I’ll even venture more could merge. Frontier is a classic example of why this industry is not out of the woods.  And why even the network carriers are not done.  And why the regional carriers are not done.  Isn’t it interesting that Sean Menke, the former head of Frontier just joined Pinnacle Airlines – a truly regional carrier at this point in the industry lifecycle?  What does he know that the rest of us do not?  Me thinks that the domestic market will also be made up of today’s regional carriers; today’s low cost carriers and of course; today’s network carriers as Jeff Smisek, CEO at the new United said, "A domestic operation sized solely to feed our international traffic".  It will be different no matter what pilot scope clauses suggest.

Airline Stuff: A Little of Last Week; A Little of This Week; A lot of Cynicism

Consolidation; the National Mediation Board; APFA; Republic Holdings and Captain Prater

Last week, Reuters held its Travel and Leisure Summit in New York.  A number of airline CFOs participated, including Kathryn Mikells of United, Tom Horton of American, Derek Kerr of US Airways and Laura Wright of Southwest.  It was, overall, a really good group of voices who spoke pretty much in concert about the challenges facing the airline industry. Then came the sour note, from another invitee, Captain John Prater, president of the Air Line Pilots Association, whose. comments nearly caused me to choke on Cheerios. But more on that later.

Consolidation was the big storyline in the coverage.  Southwest continues to not rule out the possibility of a merger, although Wright made it clear that organic growth is its preferred route.  Mikells talked more broadly about consolidation and did not limit herself to discussing consolidation within sovereign borders.  Kerr, too, spoke favorably about consolidation but suggested that merger activity would have a more positive effect on the industry’s fundamentals if it involved a carrier with a US domestic presence.

"It's five major carriers, it's too fragmented," Kerr said of the U.S. airline industry. "You have too many hubs, all chasing the same passengers trying to connect through the country. We believe that it needs to be consolidated."

One issue that puzzles me though is that the consolidation discussion focuses only on the five legacy carriers. I think the most interesting sector for consolidation is the regional sector (on which, as it turns out, Prater appears to agree with me.)  But why are names like Alaska, jetBlue and AirTran not part of the discussion? What about Air Canada?  Is consolidation limited to just two carriers?  What if United, or American, or US Airways, wanted to sell part of their domestic operation to one carrier and another part to a third carrier? That concept is not so different than the slot swap deal that Delta and US Airways negotiated only to have the government make such dramatic changes to the terms of the deal that it now makes no sense.

Now back to Prater. In his remarks, Prater said that ALPA is for what he called the “right: consolidation – one that “actually protects and enhances jobs and creates a profitable carrier."  Just to be sure, I read it twice.  Yep, those were the words of the same pilot leader who has done little to nothing for his membership for the past three years.  Then I remembered that it is an election year at ALPA. Maybe that is why Prater’s words and tone have changed to better mirror what Captain Moak said and carried out at Delta during its largely successful merger with Northwest. 

Where was Prater when the US Airways and America West guys needed leadership?  If my memory serves, I believe he was flexing his muscles after winning election on a “we will take it back” campaign.  Of course, there is still little evidence to suggest that United is any better positioned than any other legacy carrier to return to the days of the bloated and inefficient labor contracts that helped tipped the carrier into bankruptcy. So Prater might be testing out a new campaign platform to convince UAL pilots that he deserves a second term.

From the management perspective, the CFOs wholeheartedly agreed that capacity discipline is the key for the industry to become and possibly remain profitable.  They also agreed that alliances are here to stay as the industry’s answer to mergers across borders that are forbidden by rules and regulations. 

"What you will see United and other industry participants doing, is basically within the regulatory framework that we have today, trying to get some merger-like benefits without merging," United's Mikells said.  The discussion that followed focused on the big three alliances and their efforts to find cost synergies as well as the revenue synergies already in place.

And that’s where airline labor comes in.  In the past, many unions have been cool to any merger that might threaten the union’s stranglehold on flying for its own members, even when that flying comes at a high price. Prater’s ALPA, for example, is a loud opponent of global mergers, even when the alliances in place today support so many pilot jobs in the US.  Surely he does not think that each of the five legacy carriers would be as big as they are even today if they were not carrying alliance partner traffic?  So the “consolidation that actually protects and enhances jobs” he talks about actually occurs every day when that United flight leaves Washington Dulles for Frankfurt with 60 percent of its passengers bound for points beyond Frankfurt on STAR partner Lufthansa.  Just like the American Airlines flight leaving Washington Dulles for Los Angeles that is carrying a cabin full of passengers connecting with Qantas to Sydney and beyond?

Republic Is Confusing, Confounding

What the Hell Is Republic Doing?  I get notes from really smart people in the industry asking me this question.  After all, I was really jazzed over the prospects for Republic’s purchase of Frontier and wrote a lot about the possibilities here on swelblog.  Now I am confused.  First, I have not understood the level of management energy spent on the presumption that Midwest can be reborn.  TPG had already destroyed the carrier literally and figuratively.  I can see the possibilities of keeping in place some of Midwest’s best flying.  But messing with Frontier’s brand to right-size Milwaukee makes absolutely no sense.

Ann Schrader of the Denver Post wrote about Republic’s “bumpy integration” in her February 21 story Merger muddles Republic Airways' branding. I appreciate that piecing together an airline is much easier said than done.  But every day Republic seems to further confuse the confusion.  And if serious industry watchers are confused, then just imagine how former loyalists to Midwest and Frontier must feel. It is those loyalists that are the brand – or maybe were the brand?  I am a Daniel Shurz fan and I have every confidence that he can get the right aircraft in the right place at the right time.  But there is much more to this delicate exercise than moving airplanes and picking markets.

I will buy the decision to dismantle Lynx (Frontier’s regional operation) given that it would have taken many more aircraft in the Q400 fleet to realize scale economics.  Now Republic has placed an order for Bombardier’s C-Series airplane.  On paper the aircraft is interesting – but why have orders been so hard to come by – unless someone needed to trade out of an aircraft type?  Then Republic puts an unproven engine on a not yet embraced airframe.  Confused. 

A big part of the Frontier and Midwest brands was the people.  This is about as bad a job of managing work forces as I have witnessed.  Given the new representation rules likely coming this week from the National Mediation Board, Bedford’s Republic promises to be a ripe target for union organizers.  Surely this is not Bedford making these calls?  I have gone so far to say that Republic will play in tomorrow’s US domestic market in a meaningful way.  Now I am not so sure.   And I am simply confounded by any decision to upset the work force at Frontier.

The way this seems to be playing out is that under Republic, both the Frontier and Midwest names will disappear.  So why then buy Frontier, an acquisition clever because Republic was buying a great brand. The deal in fact gave Republic an actual airline – something Republic is not.  The purchase also bought Republic a management team that knew how to run an airline and an IT infrastructure that made the deal really interesting.  But now it seems that Republic’s management team thinks you can feed a cookie (Midwest) to Grizwald or Montana (Frontier) and out comes Herman the Duck (Republic).  Remember that brand?

The National Mediation Board

This is a week to pay attention to the National Mediation Board. Jennifer Michaels at Aviation Week reports that the Board’s “cram down” representation rule change will be published in the Federal Register on Friday.  I believe that there will have to be some comment time or at least that is the way things used to work in Washington prior to this administration.  Unfortunately this issue is playing out the way the health care debate is playing out – along party lines.

The other story playing at the NMB this week involves American Airlines’ which is again in “lock down” negotiations with its flight attendant union, APFA.  The APFA already has threatened to request a release from the NMB if the two sides fail to reach a deal by the end of this round of talks. Whether the NMB will do so is questionable given what I see as the administration’s reluctance to risk a strike in the midst of a fragile recovery.  Moreover, we typically do not see releases during the busy travel season – particularly when economic recovery is at stake.  And rarely do we see releases when, by all reports, the parties are still pretty far apart based on what the union is demanding and the company believes it can afford.

The APFA, in all that I have read, does not seem willing to embrace any productivity in return for increased income for its members.  American has been transparent in communicating its proposals, including on a public website. So what might the NMB do with the parties if a deal is not reached?  Grant the APFA a release?  No.  Grant the APFA its release with the full intention of creating a Presidential Emergency Board?  Maybe. Put the negotiations on ice?  Maybe.  Set new dates for the parties to resume negotiations?  I think not.

Will the Board be proactive in trying to close a deal?  That is the question.  It is what watchers of this incredibly difficult round are trying to discern.  How will this NMB deal?  So far, with only a few airline labor negotiations cases closed, the NMB has not yet been pushed to the brink. But there are still 82 open cases.  The AA – flight attendant deal might be the first big test.

Europe and Strikes

Speaking of the APFA and its loose-lipped talk of strikes, last week was most interesting in Europe.  The Lufthansa pilots.  The BA flight attendants.  The French air traffic controllers.  And of course, all things Greece

Europe is undergoing today what the US airline industry has been experiencing for the past 20+ years: the need to continually transform business models with relatively high cost structures in the face of declining revenues.  Unbridled competition in the US domestic market was its catalyst to reduce costs, particularly labor costs.  The decline in premium class revenue and the blurring of borders that used to protect individual flag carriers will serve as the catalyst for the European carriers to also reduce their labor costs.

The labor instability in the European airline industry demonstrates an expected collision of socialist policies promoting entitlement with an industry forced to adapt to market forces.  I expect that there will be more weeks like this one as the European unions come to grips with market realities that could make any number of flag carriers irrelevant in tomorrow’s global airline industry. Unless, that is, those unions instead choose to adapt to the industry’s evolution . . . a story that has played out in the US in the names of Pan Am, TWA and Eastern Airlines to name a few.

It’s not just Europe.  Look at what is happening in Japan where JAL, another legacy carrier with outsized costs relative to revenue, is in bankruptcy.  Following 9/11, more than half of the US airline industry was in bankruptcy at one time.  European airlines – and their respective unions - are not immune to the same market forces.  And there are certainly lessons that can be learned from the US experience. 

Is Republic Changing the Face of the US Domestic Market?

On June 22, Reuters reported that Republic Airways Holdings Inc. (RAH) will sponsor Frontier Airlines’ exit from bankruptcy, noting that the “US regional carrier” would pay $108 million for 100 percent of the equity in the reorganized entity. The next day, Republic announced that it will buy the remains of Midwest Airlines for a mere $31 million (only $6 million in cash), from TPG, the private equity group that has had some success in the US airline industry. While the story got some play in the mainstream press, the possibilities are much bigger than many may realize.

Think About It

Prior to these announcements (and keeping in mind that the Frontier deal is subject to Bankruptcy Court approval), Republic Airways Holdings was soley in business as a provider of “regional airline” capacity. The holding company offers potential purchasers three brands: Chautauqua Airlines, Shuttle America, and Republic Airlines. Under this model, Republic Airways Holdings operates under the flags of its contractual partners, including United Express; US Airways Express; Delta Connection; AmericanConnection; and Continental Express. Therefore it has its fingers into each of the five legacy carrier networks

RAH’s CEO, Bryan Bedford has been in this industry a long time. And he is smart, really smart. Bedford makes this move in an environment in which it is increasingly clear that the legacy carriers do not – and cannot – now operate under a cost structure that will support the number of airlines trying to survive in the hypercompetitive domestic US airline business.

Through May of 2009, airlines have cut capacity another 11 percent. At the same time, passenger revenue is down 21 percent versus the first five months of 2008. When compared to the heyday of 2000, mainline capacity is down 28 percent in the domestic market and passenger revenue is down 33 percent. Despite all of the work done by the legacy carriers to reduce costs – whether through the hammer of the bankruptcy court or not – these revenue trends illustrate an industry all but unsustainable in its current form. And while much has been made of the shift of capacity from domestic to international markets, those revenue trends are even worse in recent months.

Back to Republic

So what‘s behind Republic Airway’s maneuver? Consider this. Chautauqua is a carrier with relatively senior workforce and a fleet that offers little in terms of improvement in technology or scale. Shuttle America is much the same. And parts of Republic Airline’s fortunes are tied to United and US Airways where it operates the latest and greatest 70-seat technology. Happily for Republic, no other carrier is better positioned to capture this flying, in part because it owns its fleet rather than leases it from its mainline partner.

RAH’s structure allows it the necessary flexibility to provide a range of services for a range of clients. It has the flexibility to move from one segment of the business to another. The holding company is designed to work around pilot scope agreements. Nobody does it better. As a result, Republic and Bedford have built a business that provides them with a capital base that allows them to “pay to play.”

Indiana Hold 'em

Bedford “played the river” and now, in this observer’s view, has won enough chips to move to the final table. Providing debtor-in-possession financing is among the safest bets in restructuring. It results in little to no loss of capital in return for increased business. The result is a widely diversified portfolio of flying at increasing revenues as aircraft have gotten larger. Based on the cash flows, Republic has a fleet of aircraft well suited for tomorrow’s US domestic market. For Republic, the next move is building fleets in the 90-120 seat range and that will only augment its cost advantage.

The Frontier Card

Now Frontier provides Republic with something it previously lacked: a technology infrastructure that gives it long-term viability in the market. A technology infrastructure not tied to a legacy system. Today’s “regional carriers” are merely a wet lease of capacity to fly to small markets where mainline aircraft and crews cannot operate economically. They don’t sell tickets. Their purchased capacity merely moves people onto a mainline aircraft at a hub. With Frontier, Republic could change the game.

When it comes to changing the way consumers buy airline tickets, few see Air Canada as the bellwether - they were. But Frontier’s CEO, Sean Menke, came from Air Canada and brought with him the concept and a blueprint of giving consumers a choice of the services and amenities they want at a price they were willing to pay. There, he was recently joined by Air Canada’s Daniel Shurz, a marketing/strategy visionary wunderkind who has further strengthened the Frontier management team.

Frontier may well be the next new thing in the market. It’s not the Independence Air model or just another regional carrier. It is tomorrow’s solution for outdated domestic capacity. Bedford could now buy an Airbus fleet for a song. Bedford could now buy Milwaukee at a bargain. Who cares about Milwaukee? Only Southwest and AirTran and each and every legacy carrier that depends on Milwaukee traffic to feed operations at their hubs.

Imagine This Scenario. . .

1. Republic continues to collect revenue per departure for the feed it provides to each of its five current clients.
2. Republic maintains a financial interest in cities with three carriers trying to maintain or obtain market dominance. There is little evidence to suggest that many cities can support three aggressive carriers vying for market share. It’s been tried at DEN and it sure as hell cannot work at MKE.
3. Come Fall, as mainline carriers realize that previously announced capacity cuts are not sufficient, they turn to Republic and attempt to renegotiate their contracts. Republic says “Hell No” and instead makes a move to turn to develop its holding company portfolio into an airline that will compete for the very same traffic.
4. Maybe it then becomes apparent to one of those competing airlines that flying to DEN– largely reliant on feed traffic –no longer makes sense and it negotiates with Republic to replace its capacity there? Certainly, labor issues abound, but economic realities could prove persuasive.

All of this comes at a time of seachange for the big players in the US market. Ultimately, there is little left for the legacy carriers to restructure. There is no way to restructure zero demand. There is no way to restructure free-falling fares. There is no way to restructure rising fuel costs. And under current labor contracts, there is no way to restructure labor costs other than to get rid of minimum employment requirements.

That given, and with liquidations possible if conditions don't begin to quickly improve, Republic is well positioned to take advantage of vacuums in the domestic market. And we all know that nature abhors vacuums.

We’re entering a new era in the US airline industry. Change likely won’t depend on the kind of calamity or crisis that triggers the “force majeure” clause that allows airlines to suspend or break contracts. Instead, new market economics may force a restructuring of the industry in which the victors are those, like Republic, which simply have a better business model - a flexible and agile model. The top domestic airlines of tomorrow might be Southwest, jetBlue, Republic and maybe two of the five current legacy carriers.

Hubs will remain in the largest metro areas because that is where the population is gravitating. Thus, the focus of air service providers is no different today than it was in the early 1990’s when we lost Eastern and Pan Am. And once again, the industry will discover that presence in all the big markets doesn’t give them pricing power anywhere. Republic’s move demonstrates that the major carrier’s reliance on feed markets to cross subsidize this fact could be over. Air travelers want low fares and, time and again are showing they’ll drive to whatever airport – and airline -- offers them.

In the very near future, it might be a very different set of carriers that dominates the US domestic landscape.